Friday, 16 October 2009

Williamson and the theory of firm

As is well known Oliver Williamson won this years Nobel Prize in economics along with Elinor Ostrom. Williamson is one the the top theory of the firm economists around today. His work starting in the early 70's bought the theory of the firm back to life. After Coase's path breaking 1937 paper and before Williamson's contributions, very little happened in the theory of the firm. Among economists the small amount of work that did take place in this period was , by and large, ignored. Then came Williamson.

In economics textbooks, the firm is a production function or production possibilities set, a "black box" that transforms inputs into outputs. Given the existing state of technology, the prices of inputs, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. The firm is modeled as a single actor, facing a series of uncomplicated decisions: what level of output to produce, how much of each factor to hire, and the like. These "decisions," of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In short: the firm is a set of cost curves, and the "theory of the firm" is a calculus problem.

Williamson attacks this conception of the firm, which he calls the "firm-as-production-function" view. Building on Coase's (1937) transaction-cost or "contractual" approach, Williamson argues that the firm is best regarded as a "governance structure," a means of organizing a set of contractual relations among individual agents. The firm, then, consists of an entrepreneur-owner, the tangible assets he owns, and a set of employment relationships — a realistic and thoroughly Austrian view.

Williamson’s theoretical argument is fourfold. First, the market is likely to work well unless there are obstacles to writing or enforcing detailed contracts. For example, at the beginning of a buyer-seller relationship, there is usually competition on at least one side of the market. With competition, there is little room for agents on the long side of the market to behave strategically, so nothing prevents agreement on an efficient contract. Second, once an agent on the long side of the market has undertaken relationship-specific investments in physical or human capital, what started out as a transaction in a “thick” market, is transformed into a “thin” market relationship in which the parties are mutually dependent. Absent a complete long-term contract, there are then substantial surpluses (quasi-rents) to bargain over ex post. Third, the losses associated with ex-post bargaining are positively related to the quasi-rents. Fourth, by integrating transactions within the boundaries of a firm, losses can be reduced.

The first two points are relatively uncontroversial, but the third may require an explanation. Why do bargaining costs tend to be higher when it is harder to switch trading partners? Williamson offers two inter-related arguments. First, parties have stronger incentives to haggle, i.e., to spend resources in order to improve their bargaining position and thereby increase their share of the available quasi-rents (gross surplus from trade). Second, when it is difficult to switch trading partners, a larger surplus is lost whenever negotiations fail or only partially succeed due to intense haggling.

The final point says that these costs of haggling and maladaptation can be reduced by incorporating all complementary assets within the same firm. Due to the firm’s legal status, including right-to-manage laws, many conflicts can be avoided through the decision-making authority of the chief executive.

Williamson’s initial contributions emphasized the benefits of vertical integration, but a complete theory of the boundaries of firms also has to specify the costs. Such an argument, based on the notion that authority can be abused, is set forth in a second major monograph from 1985, The Economic Institutions of Capitalism (especially Chapter 6). The very incompleteness of contracting, that invites vertical integration in the first place, is also the reason why vertical integration is not a uniformly satisfactory solution. Executives may pursue redistribution even when it is inefficient.

Williamson work has lend to a renewed interest in the firm. Many empirical, policy and theoretical applications are based on Williamson's work. One of the interesting policy applications of Williamson's work is to anti-trust, or competition policy. The Nobel committee explains,

Williamson’s theory of vertical integration clarifies why firms are essentially different from markets. As a consequence, it challenges the position held by many economists and legal scholars in the 1960s that vertical integration is best understood as a means of acquiring market power. Williamson’s analysis provides a coherent rationale for, and has probably contributed to, the reduction of antitrust concerns associated with vertical mergers in the 1970s and 80s. By 1984, merger guidelines in the United States explicitly accepted that most mergers occur for reasons of improved efficiency, and that such efficiencies are particularly likely in the context of vertical mergers.

Williamson's work remains informal. In an attempt to formalise his work Robert Gibbons suggests that there are two theories within Willamson's frame work - rent-seeking and adaptation:

Thus, I do not conclude from this close textual analysis that Williamson has been inconsistent or confused or wrong; rather, I conclude that his collected works suggest two theories of the firm—rent-seeking and adaptation. Much of the literature has focused on rent-seeking, often with AQRs created by specific investments and sometimes without any mention of adaptation. Williamson himself typically emphasizes both asset specificity and adaptation—probably reflecting the view that both will be important if a full-blown theory of the firm is to be realistic, but possibly reflecting the view that both are necessary if an elemental theory of the firm is to be coherent.

Personally I think Williamson's Nobel is one of best prizes that have been given in recent times. Its also worth noting that all the big three of New Instiutional Economics, Coase, North and Williamson, have now received the Nobel.